On July 8, 1991, the Internal Revenue Service issued proposed regulations under section 446 of the Internal Revenue Code, concerning the income tax accounting treatment of notional principal contracts (NPCs). Related regulations were also proposed under section 988, relating to foreign currency transactions, and section 1092, relating to straddles. The proposed regulations (FI-16-89) were published in the Federal Register on July 10, 1991 (56 Fed. Reg. 31350), and in the August 12, 1991, issue of the Internal Revenue Bulletin (1991-32 I.R.B. 6).(1) A public hearing on the proposed regulations was held on October 7, 1991.

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our nearly 4,600 members represent approximately 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tx system that works -- one that is administrable and with which taxpayers can comply.

TEI members are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations on the application of section 446 of the Code to notional principal contracts.

Overview

The proposed regulations prescribe rules for the timing of recognition of income and deductions for NPCs. NPCs are agreements between two parties to exchange payments calculated by reference to a hypothetical or "notional" amount. As defined in the proposed regulations, the term encompases a variety of financial products including interest rate swaps, caps, floors and collars, commodity and basis swaps, currency swaps, and other financial innovations. As acknowledged in the preamble, the principal purpose and use of these instruments by nondealer corporations is to reduce the risk of changes in prices, interest rates, and currency rates.

TEI commends the IRS for undertaking to clarify the tax accounting rules for this abstruse yet practically important subject. TEI believes that the regulations, on balance, represent a logical and well-developed extension of the tax accounting rules. There are, however, several issues on which TEI disagrees with the proposed regulatory approach. With particular respect to the amortization of nonperiodic payments, TEI believes the complexity of the proposed regulations will engender compliance burdens for taxpayers -- with concomitant administrative costs to the government -- that are disproportionate to either tax policy or revenue concerns. In other areas, such as permitting integration of NPCs with the assets or liabilities hedged, we regret that the broad power of the government to prescribe tax accounting rules requiring "the clear reflection of income" has not been prudently exercised. TEI's specific recommendations follow.

Integration

The proposed regulations require separate tax accounting for each NPC. The preamble notes, however, that NPCs are frequently used to hedge assets or liabilities and, consequently, that the IRS is considering whether to permit taxpayers that hedge assets or liabilities with NPCs to account for the contracts on an integrated basis with the underlying asset or liability. Comments are requested on the issue.(2)

TEI believes that the IRS should exercise its regulatory authority to permit the integration of NPCs with the hedged assets or liabilities. In this regard, we recognize that section 988(d) expressly authorizes integration in respect of hedging transactions while section 446 does not. A question may exist whether the IRS has authority to promulgate regulations under section 446 to require or permit integrated treatment of hedges. We believe it does.

The IRS has been given broad powers under section 446 to determine that a taxpayer's method of accounting clearly reflects income. TEI believes that, in the case of NPCs used as hedges, integration provides a more clear reflection of income. Integration is consistent with the matching principles and is an accurate reflection of the economic substance of the transaction. Moreover, TEI knows of no policy reason why the IRS should not allow integrated accounting for all NPCs identified by taxpayers as part of a hedging transaction.(3)

If integration is permitted, the time of recognition and character of payments on NPCs would be determined consistently with the underlying asset or liability. This would comport with the financial statement treatment of the transactions, which allows taxpayers to account for the NPCs and the asset or liability that the contract hedges on an integrated basis.(4) Integrated tax accounting under section 446 would also be consistent with the regulations under section 988 (allowing integration for heding foreign currency denominated assets and liabilities),(5) and the temporary regulations under section 861 (which provide that gains and losses from derivative financial products used to hedge debt can be treated as an addition or reduction to interest expense on such debt).(6)

For the foregoing reasons, TEI strongly recommends that the IRS permit integration of the underlying assets and liabilities being hedged with an NPC.

Actively Traded

Personal Property

Section 1092 of the Code prescribes rules relating to nonrecognition of losses on straddles. Those loss deferral rules generally apply to offsetting positions in personal property that are "actively traded," and Prop. Reg. [section] 1.1092(d)-1 provides that actively traded personal property includes any personal property for which brokers or dealers provide regular pricing information in an established financial market. An established financial market includes a national security exchange, a domestic board of trade designated as a contract market, a foreign securities exchange or board of trade, and an interbank or interdealer market.

Under Prop. Reg. [section] 1.1092(d)-1(c)(1), NPCs generally constitute actively traded personal property for purposes of section 1092. Thus, a loss realized with respect to an NPC will not be recognized under section 1092(a) to the extent the taxpayer has an unrecognized gain in one or more offsetting positions. TEI believes that NPCs should not be considered actively traded personal property under section 1092, since there is no secondary market for NPCs. NPCs are characterized by individualized negotiation between the parties on the terms of the transaction and are affected by the creditworthiness of each party. In other words, NPCs are not "actively traded" in the same manner as stocks, options, commodities, or regulated futures contracts.

TEI is also troubled by the characterization of the rights and obligations of the parties to an NPC as an interest in personal property to the extent such a characterization causes gain or loss on termination of the NPC to be capital in nature under section 1234A.(7) One of the major issues left unresolved by Notice 89-21(8) and generally eschewed in the proposed regulations is whether income and deductions with respect to NPCs (denominated in functional currency) are ordinary or capital in character. The preamble states, however, that gain or loss realized through termination of a taxpayer's rights or obligations under an NPC will generally be treated as capital in nature. (9) TEI believes that, at least in cases where NPCs are used in hedging transactions, gain or loss should have the same character as the liability or asset being hedged. At a minimum, the IRS should defer characterizing the treatment of termination payments as capital in nature until it resolves, by further regulatory guidance, the policy issues raised by the Supreme Court's decision in Arkansas Best v. Commissioner. (10)

Termination Payments

Under Prop. Reg. [sections] 1.446-3(e)(6)(i) and (ii), any payment that extinguishes all or a proportionate part of the rights and obligations of any party under an NPC is a termination payment for all parties to the contract. Termination payments include payments to third parties where one of the original parties to the contract assigns its rights under the contract to a third party. Such an assignment constitutes a recognition event for both parties to the contract. TEI questions the propriety of requiring the nonassigning party to recognize current income when it experiences no change in its economic position. (11) Well-advised taxpayers will prohibit assignments of their NPCs without consent. Assuming that the presence of nonassignment clauses does not inhibit the market for NPCs, the IRS's position may authorize taxpayers to generate capital gains or losses on the NPCs at will simply by giving consent to an assignment. Moreover, the proposed regulations pose serious administrative problems. This is because a recognition event recorded for tax purposes may not be consistent with the financial accounting treatment (i.e., for book accounting purposes no transaction will have occurred with respect to the nonassigning party), and because the calculation of the "gain" for the nonassigning party will be computed by reference to an estimated amount rather than an actual cash payment or contractual amount. (12) TEI is concerned that, absent direct notification from the assignor or the new counterparty, a taxpayer's corporate tax department may not become aware that a "triggering event" has occurred. The required book-to-tax adjustment would likely not be made. Thus, the proposed regulations create a trap for the unwary.

Income Tax Accounting

Requirements

Prop. Reg. [section] 1.446-3(e)(3)(ii) provides that nonperiodic payments ". . . must be recognized over the term of a notional principal contract in a manner that reflects the economic substance of the contract." The proposed regulations establish broad guidelines with respect to how this general standard should be met. For swaps, nonperiodic payments are to be allocated and recognized over the term of the contract in accordance with the values of a series of cash-settled forward contracts that reflect the specified index and notional principal amount. Similarly, any payment relating to the purchase or sale of a cap or floor is to be recognized over the term of the agreement by allocating it based upon the values of a series of cash-settled option contracts that reflect the specified index and notional principal amount. Optional methods are provided for interest-rate swaps, caps, and floors. (13)

The proposed regulations provide, in effect, for backloaded recognition of the income and expense associated with nonperiodic payments. Example 1(c) of Prop. Reg. [section] 1.446-3(e)(3)(iii) implies that allocations based on the Black-Scholes option pricing model will reflect the economic substance of contracts providing for nonperiodic payments. Apparently, the goal of the proposed regulations is to require lump-sum payments to be amortized in a manner that closely approximates the assumptions used by dealers and traders in pricing these contracts. The approach, however, is problematic because dealers and traders generally quote transactions at one all-inclusive price. Thus, the proposed regulations mistakenly assume that a readily determinable allocation of nonperiodic payments exists. Dealers and traders cannot be expected to divulge (to the IRS or their customers) component pricing based on their individual, proprietary mathematical simulations of market factors.

Prop. Reg. [section] 1.446-3(e)(3)(ii)(C) specifically precludes the use of straight-line amortization of nonperiodic payments presumably on the grounds that the method "distorts" income. The method prescribed in the proposed regulations, however, is monstrously complex, especially compared with the straight-line method. More important, the forward or option cash-settlement method prescribed by the proposed regulations distorts income in any event. If the rules under the proposed regulations are not changed, corporate tax personnel (and IRS agents on examination) will have to determine allocations of lump-sum receipts and payments by reference to esoteric financial market and pricing information on a contract-by-contract basis (assuming the information is available) -- a process subject to misunderstanding, miscalculation, and misapplication, to say nothing of a process that will be both time-consuming and expensive.

TEI believes that use of a straight-line method of amortization represents a reasonable compromise between immediate recognition, which is prohibited by Notice 89-21, and the theoretically "pure" approach set forth in the proposed regulations. Precedent for a simplified straight-line approach exists in the Internal Revenue Code. Under section 1281, discount on short-term obligations is recognized on a straight-line basis, even though the method is contrary to the effective-yield method required for recognizing original issue discount on long-term instruments. Likewise, the IRS should use its general interpretative authority under section 446 to issue regulations for NPCs that are comparatively simple to administer.

TEI believes the regulations should provide an alternative amortization procedure for nonperiodic payments that is similar to current financial accounting practice. TEI understands that for financial statement purposes most users of NPCs amortize nonperiodic lump-sum payments on a straight-line basis. TEI recommends that the regulations provide an election to permit straight-line amortization of nonperiodic payments over the period to which the NPC relates. A simpler, straight-line method will substantially reduce the administrative costs and compliance burden engendered by the "precise" method of the proposed regulations. Any revenue loss to the government (assuming arguendo that there is asymmetrical tax accounting treatment between dealers and users which gives rise to a revenue loss) in adopting a "rough-justice" amortization solution would be marginal -- especially in comparison with the taxpayer's cost of compliance and the government's cost of auditing compliance with the proposed regulations. Substantial compliance and simplicity will be achieved by permitting conformity of financial and tax accounting on a straight-line basis. (14)

Conclusion

Tax Executives Institute appreciates this opportunity to present its views on the proposed regulations relating to the income tax accounting for notional principal contracts under section 446 of the Code. If you have any questions concerning these comments, please do not hesitate to call David F. Nitschke, chair of TEI's Federal Tax Committee, at (908) 750-6782 or Jeffery P. Rasmussen of the Institute's professional tax staff at (202) 638-5601.

(1) For simplicity's sake, the proposed regulations are referred to as the "proposed regulations"; specific provisions are cited as "Prop. Reg. [section]." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin.

(2) 1991-32 I.R.B. at 7.

(3) Allowing integration for non-dealers is also consistent with the proposed regulations' effective imposition of integration on dealers who hedge their obligations under NPCs. Furthermore, the IRS has shown no reticence to use its authority to prescribe anti-abuse rules under Prop. Reg. [section] 1.446-3(e)(4)(ii) for taxpayers that hedge an NPC position; in that instance, the Commissioner may require that amounts paid to or received by the taxpayer be treated in a manner that is consistent with the economic substance of the transaction as a whole.

(4) Under Financial Accounting Standards Statement 80, gain or loss on a futures contract hedge that reduces interest-rate risk is treated as an offset to interest expense. FAS 80 generally is considered to support integration in other circumstances.

(5) Temp. Reg. [section] 1.988-5T.

(6) Temp. Reg. [section] 1.861-9T(b)(6).

(7) 1991-32 I.R.B. at 12.

(8) 1989-1 C.B. 651.

(9) 1991-32 I.R.B. at 7. The proposed regulations do provide that in certain circumstances amounts will be recharacterized as interest.

(10) 485 U.S. 12 (1988). In the case of termination payments, the lump-sum payment represents the present value of all the future, interim payments to be made or received under the contract. The preamble's suggestion that such payments are capital in nature (1991-32 I.R.B. at 12) has the potential to produce a mismatch in character between the NPC used as a hedge and the underlying asset or liability.

(11) The position of the IRS presumably is based on the Supreme Court's decision in Cottage Savings Association v. Commissioner, 111 S. Ct. 1503 (1991). In that case, one of the parties to an exchange transaction deducted a loss on a disposition of interests in mortgage participations. The transaction there differs from a unilateral assignment by one of the counter parties to an NPC. The economic position of the nonassigning party to an NPC is more closely akin to that of the mortgagors whose obligations were swapped in Cottage Savings. Thus, TEI believes that it is improper to require recognition by the nonassigning party.

(13) The nonassigning party is unlikely to be privy to the details of the transaction between the assigning party and the substituted counterparty. Presumably, the nonassigning party either would obtain hypothetical quotations on the rates (premiums or prices) at which the transaction may have occurred or

would apply some other financial calculation, such as the Black-Scholes model, to derive an estimate of the amount hypothetically realized.

(13) For swaps, a cost-recovery method is provided that bifurcates the payment of the interest and noninterest components. For caps and floors, the proposed regulations provide the text of a proposed revenue procedure supplying an alternative allocation method.

(14) The IRS appears to assume that dealers use the pricing methods developed for their trading floors for purposes of accounting for the recognition of income from NPCs. Furthermore, the proposed regulations require perfectly symmetrical tax treatment between the parties to the NPC, presumably to prevent the government from being whipsawed by inconsistent accounting methods being used by dealers and users of NPCs. TEI questions whether (1) the revenue loss from asymmetrical tax accounting (assuming that dealers and users have used different methods) is significant and (2) the cure is worse than the perceived ill. If the mark-to-market election for dealers permitted under Prop. Reg. [section] 1.446-4 is widely adopted, asymmetrical tax accounting will result in any event.

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